Many of my readers keep asking me as to why I do not have different portfolios allocated to different goals of mine. I have explained this in other posts so will not repeat the basic arguments here. Suffice it to say, multiple portfolios will most likely lead to sub-optimal returns and I do not look upon it as smart financial planning at all. In fact if you really look at how you go about your life and the finances you need ta take care of your plans, the most important aspect is really cash flows.
While cash flows are kind of implicit in goal based planning – we are asked to redeem our financial investments to cater for the expenses linked to a goal – it is important to understand the true nature of it. In a recent discussion with a friend it struck me that most people do not have a clear idea about it at all and do not understand how to go about it. When I was thinking of how to explain this to my readers, I thought of how we use water in our daily lives. This is an analogy I have used in one of my earlier posts and can be used well here.
Let us assume a normal middle class household in India where we have different types of expenses such as listed below:-
- Regular monthly expenses such as food, groceries, utility bills, transportation etc.
- Quarterly or biannual expenses such as school or college fees.
- Annual expenses such as Insurance premiums, TV subscription etc.
- Irregular expenses such as clothing, purchases of personal discretion.
- Large expenses such as White goods, Vacations abroad etc
- Goals such as College admission, marriages etc.
To personalise this example let me relate it to you as a reader. For the next 12 months, list out all possible cash needs you have out of these categories. For example you may have something looking like this:-
- Monthly household expenses @ 40000, Annual costs = 4.8 lacs
- School fees @ 10000, Annual costs = 1.2 lacs
- Insurance premiums, TV service etc, Annual costs = 1 lac
- Vacations, White goods, Annual costs = 1 lac
- No large goals in next 12 months.
What does this really mean? In cash flow terms, your outflow will be to the tune of 8 lacs. So if you have got 8 lacs and more from your salary or business you are fine, right? This is unfortunately not true at all – understand that your outflows on large goals are not there now but they will occur at some point in time. When it does you have to spend and that amount may not be possible from your normal cash inflow. Let us say your son will go to a college that costs 5 lacs a year for 4 years. If this amount can be catered for through your active income, you are home and dry. If not then you must invest in the years before he gets to college so that when the time comes you have access to the money. Similarly you need to plan for your retirement – at that time you have no active income but your household expenses remain there. So, you must have some alternate source of cash inflow so that you are able to sustain your expenses.
Where does cash inflow come from? Well, there can be several sources, but some of the more common ones are as follows:-
- Salary from your job
- Income from business or profession
- Income from hobbies or other interests ( blogging etc)
- Interest income, dividends
- Rental income
- Capital gains from selling an asset
- Redeeming financial instruments
Where does the water analogy come in? Well, you can think of regular cash flows as the water that is supplied to your house every day by the City corporation. Most of your needs are met by that. However, you also store some water for an emergency that may occur. In case you are planning to clean your house thoroughly, you will plan to arrange for availability of water etc. What happens if you are having a big function at your house and you need to have a lot of water? Well, in case you have stored it in a tank etc you can use that. Alternately you can get some water tankers to get water for you. This is similar to redeeming financial instruments for a large goal. You can also stretch the thought process to look at these tankers as a loan – in that case you have to pay back the water just as you pay back through EMI for the loans.
The bottom line is this – your cash inflows either in term of current income or income from past investments or loans must match your cash outflow needs at all points in time. With the water analogy we have to look at running water, water stored earlier or water obtained from external sources such as tankers to take care of our needed consumption.
Pretty simple really, if you think of it a little and then the entire financial planning just becomes an exercise in cash flow management. How do we factor in investments into this? Well, I will cover that in another post as this one has already got quite long.